The Supreme Court in a 1992 decision, INDOPCO, Inc. v. Commissioner, held that a corporation that was acquired by another corporation could not deduct certain expenses investment banking fees; legal fees; accounting fees; printing expenses; proxy solicitation expenses; and SEC fees . that it incurred in connection with being acquired. The IRS has viewed INDOPCO (in the words of one court) as a .green light to seek capitalization of costs that had previously been considered deductible in a number of businesses and industries..
Many corporations, unfortunately, have seen the IRS deny deductions of expenses on the basis of the INDOPCO decision. In particular, after INDOPCO, the IRS routinely began to deny deductions for expenses connected in any way . however remote . to a corporate acquisition. The Eighth Circuit Court of Appeals, which includes Minnesota, has now decided a closely-watched case (Wells Fargo & Company v. Commissioner) that will limit the ability of the IRS to deny deductions for certain acquisition-related expenses.
Faegre & Benson represented the taxpayer (Davenport Bank & Trust) in the Eighth Circuit case. Davenport is a subsidiary of our client, Wells Fargo & Company, which acquired Davenport in January of 1992. The IRS denied Davenport.s deductions for a portion of the salaries it paid to its officers during 1991, when the transaction was negotiated. The IRS claimed that since Davenport.s officers spent a portion of their time working on the Wells Fargo acquisition, a portion of the salaries they received had to be capitalized (i.e., not deducted, at least until the dissolution of Davenport, if it ever is dissolved). The IRS took this position even though: (a) the officers had been hired to perform the day-to-day business of the bank (not specifically to work on acquisitions); (b) the salaries paid to the officers were unaffected by the acquisition; and (c) the salaries allocable to the acquisition were only 3 percent of the total salaries that Davenport paid to its officers.
The Eighth Circuit held that the IRS could not disallow the salary deduction solely because some of Davenport.s officers worked on the transaction. It stressed the fact that the salaries were unaffected by the acquisition, and it held that the officers. services were not .directly related. to the transaction. Thus, even though the transaction resulted in a .long-term benefit. to Davenport (a fact the IRS deemed conclusive), the Eighth Circuit held that the salaries could be deducted because they were only .indirectly related. to Wells Fargo.s acquisition of Davenport.
This is a very important decision for corporations involved in mergers and acquisitions. The IRS approach, had it been upheld, might have required corporate executives to maintain time records in order to allocate their compensation between deductible and nondeductible activities. While the Eighth Circuit.s decision does not go so far as to hold that the IRS can never capitalize salaries . for example, a court might hold that salaries paid to employees whose duties consist primarily of working on acquisitions to be nondeductible . the Eighth Circuit.s decision should support the deductibility of salaries in the majority of cases.
A second issue in the Wells Fargo case was whether a portion of the fees paid by Davenport to its attorneys could be deducted. In INDOPCO, the Supreme Court denied a deduction for all of the target corporation.s legal expenses. Davenport, however, was careful to limit its claimed deduction to legal expenses incurred for investigating the products, services and reputation of the acquiring company. Although the Tax Court held against Davenport on this issue, the IRS on appeal confessed that the position it took in the Tax Court was wrong, and it acknowledged that legal expenses of this type could be deducted for services performed through the date of the .final decision. to proceed with the acquisition (provided that the acquisition resulted in an .expansion. of an existing business). The Eighth Circuit upheld a deduction for legal fees for .investigatory services. performed through the date the parties entered into the formal acquisition agreement.
The IRS concession (coupled with the Eighth Circuit.s decision) results in an important limitation on INDOPCO that goes beyond the issue of legal fees. Fees paid for .investigatory services. performed through the .final decision. to proceed with an acquisition . whether paid to lawyers, accountants or investment bankers . are deductible if the acquisition results in an expansion of an existing business. Distinguishing such .investigatory services. from other services is, of course, not always easy. Professionals providing investigatory and other services should be encouraged to identify fees for investigatory services in their billings, to the extent possible. Moreover, if the fees are substantial, professional tax advice should be sought.